We have downgraded our long-term recommendation on the largest U.S. airline United Continental Holdings Inc. (UAL) to Underperform from Neutral. We believe escalating fuel prices, weak traffic volumes and the March 11 catastrophe in Japan will hurt the company’s profits over the year.
Persistently rising fuel prices since last December have surfaced as a major headwind for the airlines industry. Crude oil prices are currently trading around $110 per barrel, representing the steepest rise in more than two years. Oil prices have already risen more than 21% this year due to the ongoing political unrest in the Middle East.
U.S. carriers are struggling hard to deal with increasing costs either by flying less or charging more. In order to counter the rising fuel prices, United Continental Holdings plans to cut its capacity approximately by 1% in May and 4% in September. With these reductions, the company expects its domestic capacity to decrease 5% and international capacity to increase 2% in the fourth quarter of 2011.
Following the massive earthquake and tsunami in Japan, air carriers are making drastic cuts in their capacities. People are scared to fly to Japan due to the still unsettled nuclear situation. The drop in demand for air travel to the country is hurting overall airline profitability.
In a move to control the situation, United Continental is expected to slash 10% of its capacity in April and 14% in May for flights operating between Tokyo and U.S. cities like New Jersey, Los Angeles, Seattle and Washington.
The company is cutting its capacity more than its rivals Delta Air Lines Inc. (DAL) and American Airlines, a wholly owned subsidiary of AMR Corporation (AMR), to combat the difficult situation arising from the Japan crisis as well as high fuel prices. The reduced capacity will restrict revenue growth going forward.
Further, we believe Japan’s disaster and higher fuel will stall the ongoing recovery of the U.S. airlines industry. In addition, high unionization, competitive threats and capacity cuts might pose major risks to the company’s profitability going forward.
However, we believe United Continental will likely be able to have everything back under control as conditions stabilize in Japan. In all probability, the capacity cuts are temporary, and should last only for the next two–three months. Also, the company is combating rising fuel prices with higher fares and extra fees. United Continental hedges its fuel position, which protects it from rising fuel prices.
Hence, for the short term (1-3 months), the stock retains a Hold rating with the Zacks #3 Rank. We, further believe United Continental will continue to benefit from merger synergies, global network, strong competitive positioning, low costs, fleet optimization and a strong liquidity position.